Krugman and The Failure of Economics

In a recent article in
the NY Times Op-Ed section, economist Paul Krugman points out that in the time
it was most needed, economics failed. Let's first start by defining economics.
According to Webster, economics is,

A science concerned with the process or system by which goods and services
are produced, sold, and bought

In my book, E$caping Oz, I derived
four economic laws to help readers understand some basic truths about some
of the things occurring in the economy. My fourth economic law says,

Economies are expressions of what people do. Participants in an economy act
on their own selfish behalf in a manner that meets the satisfaction of others
acting on their own behalf. The collective action of all these participants
is what I call the Market, or the economy. So according to Krugman, the science
of producing, selling, and purchasing goods and services failed us or the collective
of the Market did.

According to Krugman,

Few economists saw the crisis coming -- mainly, I'd argue, because few realized
how fragile our deregulated financial system had become, and how vulnerable
debt-burdened families were to a plunge in housing prices

It really stretches the imagination that economists were unable to discern
that any debt-burdened entity would somehow be immune to a drop in the price
of the very thing that caused their debt. This sounds more like a failure of
economists and not economics.

Continuing with the Op-Ed piece, Krugman postulates that our problems are
the result of one simple reason.

We were suffering from inadequate demand.

If I understand him correctly, the demand stimulated by debt-burdened families
was somehow inadequate during the boom years pre-2008. Now that the Market
(individuals acting on their own behalf) wants a reprieve from debt accumulation,
he suggests we have inadequate demand. He accurately states that the financial
crisis caused people to want to spend less, which led to a decline in incomes
and a depressed economy. Certainly that is the Market's natural reaction to
excessive debt accumulation.

Krugman's next volley was directed at bankers, business leaders, and public
officials. After the onset of the financial crisis, the federal government
sought to cure the inadequate demand problem with a $700 billion stimulus bill.
But those bankers, business leaders, and some public officials, insisted that
such stimulus, and the huge budget deficits that followed, would lead to high
interest rates and inflation. Krugman suggests economists knew better. Economists
knew the world was awash in "excess savings" that needed a place
to go - what better place to go than government coffers! Because they would
go to government coffers, Krugman posits that interest rates and inflation
would remain low.

Let's examine these conclusions. First, interest rates are low because the
Fed has kept the rate they control (discount rate) at levels that can best
be described as knee-high to a grasshopper. Next, the Fed has been a huge buyer
of government debt, which also contributes to keeping longer term interest
rates low. If the world was somehow awash in excess savings, I guess Professor
Krugman must have thought those excesses were going to come from the Fed. Ask
people on fixed incomes, who relied on government bonds, about the Fed's low
interest rate policy. The Fed has now created a chase for yield and risk.

Remember the economic malaise in Greece? In April the Greek government floated
a $4 billion bond offering at 4.75%. This is the country with officially reported
unemployment of 25%. The low interest rate on the bond offer is astounding
but perhaps not as much as the fact the offer was oversubscribed by seven times!
Covenant-lite and leveraged loans have exceeded the peaks from 2007. Think
about that for a moment. Investors are willing to assume more risk now than
they were at the bubble peak of 2007.

One final point about "excess savings" flowing into government
bonds. There is a certain amount of hubris in believing that the best place
for excess savings should be the federal government. I have written before
on the role of the federal government (Ch 6 and 7 in E$caping
Oz). If excess savings get funneled to the government, then we are not
really allowing the participants in the market to satisfy themselves by satisfying
others (Economic Law #4 mentioned earlier). Government financing should come
from tax revenue and not from excess savings. At best government is an inefficient
transmission mechanism for directing money towards something the Market may
actually want. At worst, it is not only an inefficient mechanism but a poor
allocator of funds directed at things the Market does not want.

Now let me address his point about inflation resulting from all this extra
government spending. Conventionally-speaking the extra government borrowing
need not necessarily be inflationary. Inflation results from an increase in
the money or credit in an economy. If the extra government financing came from
excess savings, then no new money or credit was created since it already existed.
If the government financing came from the Fed by way of monetization of debt,
then it is inflationary. So you might ask, with all the Fed monetization of
debt to the tune of trillions, why are we not in a raging inflation? Did the
economists and Krugman actually get this one right? Not exactly.

The reason we are not in a raging inflationary environment is what happened
pre-2008. For this I introduce another one of my economic laws.

The period from 1982 to 2007 can only be described as the greatest expansion
of credit (inflation) in history. Once the credit expansion reaches a particular
level (only decided by the participants in the market), credit expansion stops,
collateral deflates in price and the previous confidence expressed by market
participants evaporates. So the market post-2007 did exactly what it was supposed
to do - deflate. The effect of inflation, rising prices, came to halt in financial
assets, and the deflation process (a lack of confidence and a fall in prices)
began in earnest. The monetary and governmental authorities recognized this,
and began the counteroffensive of creating MORE credit to stave off the deflation.
The results of their action includes massive increases in federal debt, and
massive increases in financial assets owned by the Fed. Moreover, their actions
have re-inflated financial assets and pushed investors towards riskier bets.
Thus, the catharsis necessary in the economy never got a full chance to express
itself.

Krugman continues by blaming a falling
deficit in fiscal 2013 and lower discretionary spending for the country's
anemic economic growth. For Krugman, it is illogical to not rely on his brand
of economics (higher deficits/more spending). I suppose the approximately
$5.5 trillion in federal deficits from fiscal 2008 to 2012 was an insufficient
number. Even if you add the reduced deficit for 2013 (north of $600 billion),
the U.S. added over $6 trillion in 6 fiscal years. That begs the question
- how much deficit spending is actually required to achieve Mr. Krugman's
desired growth?

I don't know the answer to that question and I suspect Mr. Krugman does not
either, and that is precisely the point. No one in academia or government can
push buttons and pull levers to determine these things. Remember my Economic
Law #4 - Markets allow people to satisfy themselves by satisfying others. People
know their economic condition better than our Wizards. Cycles are a natural
part of economies. Why? Because economies are comprised of humans and like
it or not, humans behave cyclically. The Wizards can embellish a cycle and
attempt to alter it, but they are unable to change human behavior in the long-term.

If economics failed, then the market's participants, all of them, somehow
failed to act in their own best interests for the benefit of others. I won't
be the one labeling millions of market participants as failures.